Virtus Enhanced Core Equity Series
4Q 2016 COMMENTARY
MARKET — The U.S. stock market had strong performance in the final quarter of 2016, despite a brief risk flare in early November related to the U.S. presidential election. Since that event, volatility levels, as measured by the CBOE Volatility Index (VIX), have declined to levels near all-time lows.
PORTFOLIO — Both the Series' equity portfolio and options overlay strategy performed well during the quarter. Of particular benefit during the quarter was a significant overweight to financials, which was the best performing S&P 500® sector in the quarter.
OUTLOOK — In early 2017, we have observed that sector leadership has recently become more reliable, although more time is needed to recognize this as a true market trend and not a temporary return to normal market functioning. At the same time, market volatility levels have been unusually low, as they were for much of the fourth quarter, especially after the election.
During the fourth quarter of 2016, the U.S. stock market had strong performance, gaining 3.81% as measured by the S&P 500® Index, nearly identical to its performance in the third quarter. The path to this result was quite different though, as the market experienced a brief risk flare surrounding the U.S. presidential election in early November. Volatility levels, as measured by the CBOE Volatility Index (VIX®) reached levels not seen since the summer, although even that spike was just above long-term average levels. The market rally that followed from this hiccup was strong over the rest of the quarter before finally losing steam in the last few days of December.
What new economic information caused this pause in the rally? The best theory we can come up with is that market participants were mindful of the Dow Jones Industrial Average crossing above the 20,000 value level. While an arbitrary and somewhat irrational concern, it certainly is in keeping with some of the other irrational behavior we saw over the course of 2016 (and all of recorded human history for that matter). Investors, or more accurately traders in this case, occasionally will buy and sell (often using highly liquid, index-based passive products) with “support” and “resistance” pricing levels in mind. This can become self-fulfilling at a large scale, as the mere expectation of what other traders may do around a key level can be enough to influence behavior.
Both the Fund’s equity portfolio and the options overlay strategy performed well during the quarter. Of particular benefit during the quarter was a significant overweight to the financials sector, which persisted over the course of the full quarter. As financials was by far the best performing sector during the quarter, this overweight proved to be constructive to overall portfolio performance.
In addition to gains made in the equity portfolio, the options overlay strategy continued to contribute positive performance. This strategy seeks to profit by selling out-of-the-money puts and calls, with strike prices below (for the puts) and above (for the calls) current S&P 500 Index values at the time of trade initiation. To manage risk, the strategy buys back puts and calls at even wider strike prices, helping to create a well-defined maximum loss amount for each trade. In most cases, the vast majority of the upfront premium earned on each trade is retained as profit at expiration, as the market rarely moves outside of the range established by the short puts and calls. In our experience, when significant losses do occur, they tend to be due to steep and sudden market declines, such as we saw in the first quarter of 2016.
A notable event during the fourth quarter was that the options overlay strategy experienced a loss on a trade in the middle of December. This was interesting for two reasons. First, the success rate for this strategy is quite high, with over 90% of historical trades expiring profitably. Second, the loss was due to market appreciation, not market depreciation. It was the first time the strategy had experienced a loss due to market appreciation. Fortunately, upside moves tend to be of smaller magnitude than downside moves, and the loss on the failed trade was on the order of 0.10%.
In early 2017, we have observed that sector leadership has recently become more reliable, although more time is needed to recognize this as a true market trend and not a temporary return to normal market functioning. Associated with this renewed sector leadership, those sectors that are currently driving the market upward are leaning more towards “bull market” sectors – such as consumer discretionary and basic materials. While we do not attempt to draw conclusions about future market directionality from this data, we typically find that momentum-based strategies, such as that employed by the Fund’s equity portfolio, work better when bull market sectors are driving strong markets.
As we saw during much of the fourth quarter, especially after the U.S. election, the volatility environment continues to be unusually depressed. While the options overlay strategy does not depend on elevated volatility levels to produce profits, it can lead to a narrower range between the short options. To the extent that there are sudden, large market moves, the strategy can experience losses. Given the unusually low levels of current volatility, and the mean-reverting nature of volatility in general, we expect that normal levels will eventually be regained.
The fund class gross expense ratio is 1.22%. The net expense ratio is 0.98%, which reflects a contractual expense reimbursement in effect through 4/30/2017.
Average annual total returns reflect the change in share price and the reinvestment of all dividends and capital gains.
Performance data quoted represents past results. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. Investment return and principal value will fluctuate so your shares, when redeemed, may be worth more or less than their original cost. Please visit Virtus.com for performance data current to the most recent month-end.
Index: The S&P 500® Index is a free-float market capitalization-weighted index of 500 of the largest U.S. companies. The index is calculated on a total return basis with dividends reinvested. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and it is not available for direct investment.
The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 Index option prices.
Support and resistance levels: Technical analysis terms related to stock prices. Support is the price level through which a stock seldom falls, while resistance is the price level at which a stock seldom surpasses.
The commentary is the opinion of the subadviser. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.
The investments for the Series are managed by the same portfolio manager(s) who manage one or more of the other funds that have similar names, investment objectives and investment styles as the Series. You should be aware that the Series is likely to differ from the other mutual funds in size, cash flow pattern and tax matters. Accordingly, the holdings and performance of the Series can be expected to vary from those of the other mutual funds. Shares of the separate Series of Virtus Variable Insurance Trust are sold only through the currently effective prospectuses and are not available to the general public. Shares of the VIT Series may be purchased only by life insurance companies to be used with their separate accounts which fund variable annuity and variable life insurance policies or qualified retirement plans. The performance information for the Series does not reflect fees and expenses of the insurance companies. If such fees and expenses were deducted, performance would be lower.
Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk.
Call/Put Spreads: Buying and selling call and put option spreads on the SPX Index risks the loss of the premium when buying, can limit upside participation and increase downside losses.
Portfolio Turnover: The fund's principal investments strategies will result in a consistently high portfolio turnover rate. A higher portfolio turnover rate may indicate higher transaction costs and may result in higher taxes when fund shares are held in a taxable account.
Fund of Funds: Because the fund can invest in other funds, it indirectly bears its proportionate share of the operating expenses and management fees of the underlying fund(s).
Industry/Sector Concentration: A fund that focuses its investments in a particular industry or sector will be more sensitive to conditions that affect that industry or sector than a non-concentrated fund.
Prospectus: For additional information on risks, please see the fund's prospectus.